Growing Appeal Of Fixed Income ETFs

Despite representing only 20% of the ETF asset base, fixed income ETFs gathered a record $156 billion in net inflows in 2019, nearly as much as more widely used equity ETFs. Year to date through Feb. 7, fixed income ETFs gathered $22 billion of net ETF inflows (31% share), according to First Bridge Data, a CFRA company.

Demand likely stems from a combination of factors, including investor unease about continual highs reached for equity markets, but CFRA also thinks a main contributor has been the growing comfort investors have with ETFs over just owning individual bonds or mutual funds. Below we review some fixed income ETFs.

Diversification

Relative to individual bonds, fixed income ETFs offer diversification. Rather than owning an individual bond issued by BBB-rated AT&T, the exposure investors in the iShares iBoxx Investment Grade Corporate Bond (LQD) have to the communications services company is counterbalanced by the 99% of fund assets in bonds from other investment-grade issuers. These include Citigroup, CVS Health, General Electric and J.P. Morgan.

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

Beyond the issuer- and sector-level diversification, LQD offers credit-exposure diversification, as more than half of its assets are in bonds rated A or higher by major rating agencies. This protects from default risk.

Mutual funds provide similar diversification benefits as ETFs, but have less liquidity, often incur style drift and tend to cost more.

Liquidity/Price Discovery

While many bonds do not trade regularly on a daily basis—creating a challenge for those individuals or mutual funds that may be looking to sell them—many fixed income ETFs trade frequently each day. Indeed, CFRA Research shows that 136 fixed income ETFs trade more than 100,000 shares on a daily basis, and 44 trade more than 1 million shares.

The 1 million shares-traded club includes funds from often less liquid investment styles such as the Invesco Senior Loan ETF (BKLN), the SPDR Bloomberg Barclays High Yield Bond ETF (JNK), the VanEck Vectors J.P. Morgan Emerging Markets Local Currency Bond ETF (EMLC) and the Vanguard Total International Bond Index (BNDX).

Investors considering whether to exit a position in EMLC, for example, in the middle of the day, can have confidence they can complete the trade and have price transparency in advance to determine if they want to sell. Mutual fund shareholders have to wait until the end of the day and only find out the share price they received after their position has been sold.

Limited Style Drift

Unlike actively managed mutual funds, ETFs such as LQD and JNK reveal their holdings daily and seek to replicate indexes that limit what they can own. For example, LQD only holds investment-grade bonds (those rated BBB and above), and JNK only holds high-yield bonds (those rated BB and below).

When a bond no longer meets the ratings criteria, the security is removed at the next monthly rebalance. This is not the case for active high-yield mutual funds, and indeed, some of the high-yield funds with the most assets have a high-single-digit percentage in bonds rated BBB or higher, according to our research.

For advisors or investors building asset allocation strategies with a targeted position in investment-grade and or high-yield bonds, the style purity ETFs offer can be ideal in contrast to active mutual funds that regularly incur style drift.

Costs

The fees for ETFs continue creeping lower annually, as asset managers aggressively compete to capture investor interest. JNK’s 0.40% expense ratio is much lower than the average 1.0% fee for high-yield bond mutual funds, which is appealing to advisors and investors who want to put more of the money to work to own bonds, and less in the pocket of asset managers.

However, there are even cheaper ETF alternatives to JNK. The iShares Broad USD High Yield Corporate Bond (USHY) and the Xtrackers USD High Yield Corporate Bond ETF (HYLB) are among the more popular ones with fees below 0.25%. In the past year, cost-conscious investors put more new money into USHY and HYLB than in JNK. In response, State Street Global Advisors, the firm behind JNK, now offers the SPDR Portfolio High Yield Bond ETF (SPHY), its own very-low-cost high-yield ETF.

What About Active Management?

In contrast, the appeal for fixed income mutual funds has been active management. For some investors, the fixed income market is too complicated to navigate on their own, while others appreciate that skilled managers can support a core strategy by diversifying across government, investment-grade, high-yield corporate and international bond sectors attempting to outperform index-based strategies.

While there are more such actively managed mutual funds, some of the largest firms offer or subadvise fixed income ETFs. These include the Fidelity Total Bond ETF (FBND), the First Trust TCW Opportunistic Fixed Income ETF (FIXD), the PIMCO Active Bond ETF (BOND) and the SPDR DoubleLine Total Return Tactical ETF (TOTL). With these products, investors gain the liquidity and price discovery benefits of an ETF, but pay a premium relative to many index funds for the active component.

CFRA previously announced it was planning to update its forward-looking ETF rating methodology in early 2020 to incorporate additional holdings and fund-specific metrics, our proprietary data and machine-learning techniques. To provide additional insight, we are hosting a webinar on Feb. 19. Please register at https://go.cfraresearch.com/etf-webinar.

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